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Saturday, June 14, 2014

Doctors without diagnoses

You are feeling ill and you go to the doctor. The doctor says
that he/she does not know why you are ill, but no matter, take this
medicine anyhow you like and you should soon be better. If you don’t
get better, then just wait until you do. The doctor does not know why
you are ill because you have not been ill often enough in the same way
for the doctor to get a theory. This, according to top Keynesian
economics blogger, Noah Smith, is the state of understanding that
economists have about recessions or slumps in capitalist economies
(http://noahpinionblog.blogspot.co.uk/2014/06/we-dont-know-why-recessions-or.html).

Smith says: “John Maynard Keynes, Friedrich Hayek and Irving
Fisher wrestled with this question in the 1930s….but almost a century
later, despite sending some of our best brains up against the problem,
we’ve made frustratingly little progress.” Smith goes on: “It’s
hard to overstate how few solid conclusions have emerged out of a
century of macroeconomic research. We don’t even have a good grasp of
what causes recessions. Robert Lucas, probably the most influential
macroeconomist since Keynes, had this to say in 2012: ‘I was [initially]
convinced…that all depressions are mainly monetary in origin…I now
believe that the evidence on post-war recessions (up to but not
including the one we are now in) overwhelmingly supports the dominant
importance of real shocks. But I remain convinced of the importance of
financial shocks in the 1930s and the years after 2008. Of course, this
means I have to renounce the view that business cycles are all alike!’

Smith notes that neoclassical perfect market equilibrium theory has
nothing to say on imperfect, highly volatile capitalist market
fluctuations. Now I have quoted Lucas before and his fellow neoclassical
Nobel prize winner and founder the Efficient Market Hypothesis (that
i.e. markets know best and we don’t know markets) Eugene Fama, to show
they don’t know what causes slumps and moreover they don’t care (see my
paper, The causes of the Great Recession.).
Smith goes onto to deliver a load of other quotes from leading
mainstream economists, past and present, who say they don’t know what
causes recessions.

What debate there is about recessions under capitalism is no more scientific, according to Smith, than
“medieval doctors arguing over leeches versus bleeding… without a real
understanding of what causes recessions, our medicines are largely a
shot in the dark.”

But Smith says the reason why mainstream economics has no explanations is the lack of data. “Business
cycles are few and far between. And business cycles that look similar
to one another — the Great Depression and the Great Recession, for
example — are even farther apart. … The main statistical technique we
have to analyze macro data — time-series econometrics — is notoriously
inconclusive and unreliable, especially with so few data points.” Smith concludes that “The
uncomfortable truth is this: The reason we don’t really know why
recessions happen, or how to fight them, is that we don’t have the tools
to study them properly. The fact is, there are just some big problems
that mankind doesn’t know how to solve yet.”

But this is nonsense. Mainstream economics has nothing to say about
capitalist crises not because there is a lack of data, but because their
theories are just plain wrong or do not even address the issue.
Contrary to the assumptions of the mainstream, markets are not perfect;
economies do not tend to equilibrium steady growth paths; and investment
does not depend on ‘effective demand’ but on profit.
While mainstream economics may have nothing to say about the cycle of
booms and slumps under capitalism, what about Austrian economics (too
much credit and malinvestment) or heterodox economics (inherent
financial instability) or Marxist economics (the law of declining
profitability)? Smith ignores all these explanations completely. For
him, ‘economics’ is either neoclassical or Keynesian; and he is right,
they have nothing to say on the causes of crises.

Even there, Smith does not deal with the latest versions of an
explanation. The Great Recession, according to Ben Bernanke, was a
traditional banking crash or ‘financial panic’, caused by the lack of
regulation. The alternative fashionable theory is that the Great
Recession was caused by wages being held down, allowing inequality to
rise, thus forcing households to accumulate too much debt that
eventually came crashing down.

This latter theory is the dominant one among heterodox circles,
leaning on the inequality data of Piketty and others. A new book just
released (House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again,
by Atif Mian and Amir Sufi), has been praised as the best explanation
by Keynesian economics elitist, Larry Summers. In a review, Larry tells
us that House of Debt “looks likely to be the most important
economics book of 2014; it could be the most important book to come out
of the 2008 financial crisis and subsequent Great Recession.” So not Piketty, then.

Summers tells us that it refutes the Bernanke thesis and “persuasively
demonstrates that the conventional meta-narrative of the crisis and its
aftermath, which emphasises the breakdown of financial intermediation,
is inadequate.” So it was not the banks that caused the crisis but
that old Keynesian cause: a lack of consumption. This is music to
Summers’ ears because in the years before the Great Recession, he firmly
rejected suggestions that a huge credit bubble was being fostered by
the deregulation of the banking industry. He had firmly supported
allowing banks to do what they liked when Treasury secretary under
Clinton. He dismissed claims then that financiers were
creating’financial weapons of mass destruction’.

Summers is now pleased to be told that he was not wrong then. The
explanation of the Great Recession is to be found in too much mortgage
debt and a lack of consumption. Summers quotes House of Debt
approvingly: “spending on housing and durable goods such as
furniture and cars decreased sharply in 2006 and 2007, well before any
financial institution became vulnerable. Likewise, they note that the
initial impetus behind recession in the US appears to have been a
decline in consumer spending.Summers goes on: “They argue
that, rather than failing banks, the key culprits in the financial
crisis were overly indebted households. So their story of the crisis
blames excessive mortgage lending, which first inflated bubbles in the
housing market and then left households with unmanageable debt burdens.
These burdens in turn led to spending reductions and created an adverse
economic and financial spiral that ultimately led financial institutions
to the brink.”

But this crude Keynesian view is equally false along with the lack of
banking regulation argument. Throughout the period prior to the Great
Recession, US consumer spending rose as a share of GDP while wages at
work dropped as a share. It was not squeezed.
Yes, this was partly due to a rise in debt, but also because
households were compensated for wage stagnation with better social and
health benefits. Yes, consumption fell in the crisis but not before
investment collapsed, as I have shown on numerous occasions in this
blog. It’s investment that is the swing factor in recessions and
recoveries, not consumption. Or to be more exact, it is profits that
call the tune, because investment demand drops off when profits do. As
profitability falls over time, eventually the mass of profit will fall
and this will force weaker businesses to cut back on investment or even
close down. Then there is a cascade of falling ‘effective demand’ as
companies go bust or lay off labour. Then consumption falls. That is the
order of events – as the graph of US profits and business investment
below shows.
Of course, talk about profitability and investment as causes of
recurrent crises is ignored or dismissed by mainstream economics of
either wing, neoclassical or Keynesian. The mainstream does not want to
focus on the exploitation of labour and profit. The neoclassical wing
either denies that there are recessions or that we can forecast or
explain them. They are just unknown ‘shocks’ to an otherwise great
system of production (see Lucas quote above). The Keynesians talk
vaguely about ‘lack of demand’, which is really a tautology because a
capitalist slump is a lack of demand for goods and labour, by
definition. It is no explanation.

Keynesian economics is less interested in how an economy gets into a
slump and more on how to get out of it. As Keynesian guru, Paul Krugman,
put it in his book on the Great Recession, End the Depression Now!:“the
point is that the problem is not with the economic engine, which is as
powerful as ever. Instead, we are talking about what is basically a
technical problem, a problem of organisation and coordination – a
‘colossal muddle’ as Keynes described it. Solve this technical problem
and the economy will roar back into life”. (http://thenextrecession.wordpress.com/2012/05/27/krugman-and-depression-economics/).

British Keynesian economist, Simon Wren-Lewis delivers the same view
in response to Smith’s view that we don’t know what causes recessions (http://mainlymacro.blogspot.co.uk). SWL says that we may not know but at least we know fiscal austerity won’t help.
“While the reasons for the Great Recession may still be controversial,
the major factor behind the second Eurozone recession is not:
contractionary fiscal policy, in the core as well as the periphery. So
this is something we really do know.” (6 June). Actually, as I have
argued in this blog, the main cause of the Euro recession, first or
second, was not austerity but the crisis in profitability. And
Wren-Lewis offers no explanation of why the Great Recession or the ‘Euro
recession’ started in the first place.

Neoclassical economists may be doctors using leeches, as Smith says.
But Keynesian economists are also doctors offering herbal remedies
without any diagnoses. Keynes once said that economists should really
become just like dentists, able to fix your teeth when there is a
problem. But even dentists need to know why problems arise in order to
fix them.

There is a viable explanation of recurrent and regular crises of
production. Marxist crisis theory, based around Marx’s law of the
tendency of the rate of profit to fall, provides a coherent one. Sure,
the lack of data is an issue. But, contrary to Smith’s view, that should
not hold back a scientific inquiry into these causes. G Carchedi and I,
among many other Marxist economists, have published extensive empirical
material that shows a convincing causal connection between
profitability, investment and recurrent slumps (see our paper, The long roots of the present crisis). And I remind my readers of the excellent theoretical and empirical paper by Tapia Granados
(does_investment_call_the_tune_may_2012__forthcoming_rpe_).

Using regression analysis, he found that, over 251 quarters of US
economic activity from 1947, profits started declining long before
investment did and that pre-tax profits can explain 44% of all movement
in investment, while there is no evidence that investment can explain
any movement in profits.

In other words, profits lead investment and investment leads demand and employment. And that’s a lot of data points.